AuthenTec Research Report
AuthenTec - The Power of Touch
(Nasdaq: AUTH)
By Chris Fernandez, PeakStocks.com
- Quick Take
- About The Company
- Financial Performance
- Potential Risks
- Why I invested in the company
- Bottom Line
I. Quick Take
(Note: Updated through the Q4/2007 (December 31st, 2007) reporting period. To get up-to-the-minute reports on AuthenTec, click on the AuthenTec link under “Topics” on PeakStocks.com)
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*Variables You Should Know About AuthenTec (Nasdaq: AUTH) |
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|---|---|
| Current Recommendation: |
HOLD |
| The Company: | AuthenTec, Inc., is a fabless mixed-signal semiconductor company that provides fingerprint authentication sensors and solutions to the high-volume personal computer (PC), wireless device, and access control markets. |
| Why Buy Now: |
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| Market Cap: |
$276.53 |
| Revenue (TTM): |
$52.34 |
| Cash/Debt: |
$66 / $0 |
| Current Price: | $10.00 |
| Risk Rating (?): | 7.5 (Moderate-High) |
| Position Size (?): | 1/4 (12-17-07), 1/4 (1-17-08), 1/4 (1-23-08) |
| Buy Around Price (?): | $13.50 (12-17-07), $13.25 (1-17-08), $12.00 (1-23-08) |
*As of 3-26-08. Except share price, all values in millions.
Quick Quote:
“Hold your shares.
Although AuthenTec has come down in price from my original recommendation, I believe that there are some things to watch out for in the next few months as the AuthenTec story plays out.
AuthenTec may very well be one of those businesses that never looks or gets “cheap”, so nibbling at these levels is probably warranted for longer term investors, but if you already own a sizeable chunk of AuthenTec, looking out into the product pipeline, and growth prospects, I believe that AuthenTec will comfortably beat analysts estimates and continue to execute.”
II. About The Company
AuthenTec – The Power of Touch
Look at your finger. Yea, that’s right, take a look at all those grooves and patterns on it.
No one on earth has that same pattern. What’s more, beneath the outside layer of skin, to where the “live” layer is, lies a unique pattern that identifies you regardless of whether you actually have any visible fingerprints or not!
This is probably one area of technology that you rarely, if ever, think about, but fingerprint security technology is getting better and better with more uses being found for this growing industry in everything from PC’s and home security systems, to cell phones and GPS devices.
I’ve found an exciting and fast-growing company that is the leader in this industry called AuthenTec (Nasdaq: AUTH).
How do AuthenTec fingerprint sensors work?
AuthenTec sensors use a unique semiconductor-based fingerprint reader that uses small RF (Radio Frequency) signals to detect the fingerprint ridge and valley pattern, thus capturing sharp and clear fingerprint patterns from the live layer of skin just beneath the surface.
The RF electronic imaging mechanism, called TruePrint technology, makes AuthenTec’s sensors less affected by common skin surface conditions — including dry, worn, calloused, dirty or oily skin — that can impair the ability of other sensors to acquire accurate fingerprint images.
This approach, which is in marked contrast with optical, thermal and DC capacitive solutions that read the surface of the skin, gives AuthenTec sensors significant advantages in image quality and in the protective coatings that the sensor can image through.
AuthenTec’s patented TruePrint technology sensors are the ONLY sensors on the market that read this live layer of skin beneath the actual surface!
Oh, and in case you were wondering, because I know some of you are, you CANNOT cut someone’s finger off and swipe it through one of AuthenTec’s sensors like in the movies!
Specifically, TrueFinger — part of the TruePrint technology - ensures that only real, live fingerprints are read by converting the properties of the skin into digital data which are delivered to the host computer for analysis.
Because of this approach, anyone who attempts to swipe the finger of a dead person in order to access their important physical or intellectual data would not succeed in getting past TruePrint.
Now that that’s out of the way…
The Power of Touch
AuthenTec’s TruePrint technology was first developed in 1998 and has been getting better, cheaper and more reliable ever since.
As you can see from the image above, all of the sensors are about the size of a dime, or much smaller and are found in a range of devices.
The best part is that TruePrint sensors are more accurate than traditional fingerprint sensors because they actually scan beneath the surface of the skin, rather than just looking at the surface.
AuthenTec uses a fabless business model whereby manufacturing requirements are outsourced to third parties. This means that AuthenTec doesn’t actually manufacture their own chips and sensors, but contracts their production out to 3rd parties, which greatly reduces their overhead and increases their margins.
While there are several types of silicon-based fingerprint sensors on the market today, including surface-reading sensors that use either the electrical or thermal properties of the skin surface to detect the fingerprint ridge and valley pattern, AuthenTec sensors are the only silicon sensors that read beneath the skin surface.
Because of this innovative approach, AuthenTec’s TruePrint technology offers many benefits, including the most accurate and reliable imaging available today.
Over 25 million sold
AuthenTec recently announced that they had shipped over 15 million of their fingerprint sensors in the past 16 months, compared to 10 million sensors shipped since the company’s founding in 1998.
AuthenTec’s growth has been accelerating rapidly, especially in the last 6 months, and I believe the market opportunity for their sensors is only just beginning.
According the company’s latest conference call, AuthenTec shipped 13 million sensors in 2007, up 85% from 7 million in 2006, which was more than double from 2005’s 3 million units. (An analyst asked if his assumption of 19 million sensors for 2008 was unreasonable, and management said it was not, which would represent a growth rate of 46%.)
By now you’re probably wondering in what sorts of devices you can find AuthenTec’s products right?
While AuthenTec’s applications for their sensors are growing, they come in 3 primary segments as outlined below: PC’s and Peripheral devices, Wireless Devices, and Access Control.
Sensors for PC’s and Peripheral Devices
In the PC market, fingerprint biometrics has emerged as the most popular biometric technology to protect critical computer information, enable convenient security and ensure convenience and personalization.
AuthenTec sensors will be used in over 300 different models of PCs, including those made by 10 of the world’s top PC manufacturers, by the end of 2008.
Their sensors have also been used in a wide range of peripherals devices, including PC keyboards, memory keys, portable hard drives, and password managers.
Some of their customers for the PC’s and Peripherals segment include: Acer, LG, Samsung, Motorola, Lenovo, HP among others.
Sensors for Wireless Devices
In wireless devices, AuthenTec sensors are used in more than 95 percent of all biometric cell phone models to protect the physical device, stored files and secure mobile commerce transactions.
As the demands of the wireless market continue to grow, service providers are introducing new and more powerful wireless devices — making wireless platforms even more valuable – and vulnerable to fraud or theft.
By installing a simple, small and discreet sensor on a phone, AuthenTec can protect the data inside from being pilfered and not detract from the phone’s functionality, usefulness or aesthetics.
In fact, by incorporating this technology on more and more phones, especially those used in business settings or to conduct business (think smart phones, etc.) or to make payments using M-commerce (more below), AuthenTec can tap an ever growing market here and abroad and expand the ubiquity of fingerprint technology where people need it the most.
Some of their customers in the Wireless Devices segment include: Casio, Fujitsu, Hitachi, Samsung among others.
Sensors for Access Control
In access control, AuthenTec’s sensors are used worldwide to protect homes, corporate buildings, government offices, airports, and other facilities.
Their sensors have been designed into a wide range of access control devices, including multiple biometric door locks, smart cards, remote RF entry keys, time and attendance readers, and other devices.
In addition, their sensors are also used in the U.S. government’s largest biometrics implementation for the U.S. Census Bureau whereby 500,000 fingerprint sensor-equipped PDAs will be used to gather information for the 2010 census.
You can see where this segment can go in terms of growth, as every house in America and around the world can implement these biometric readers for added security, convenience and aesthetics on anything from front doors, to gates, light switches, you-name-it.
Some of their customers for the Access Control segment include: Black and Decker, Biometrx among others.
AuthenTec’s Competitive Advantages
- Proprietary and Patented Technology: While other fingerprint technologies generally read only the surface layer of the skin, AuthenTec’s patented TruePrint technology is able to read the live layer of skin below the skin’s outer surface and use TrueMatch matching algorithms to use these higher quality images to accurately and securely match the user, a process which AuthenTec believes is one of the most accurate and secure matching capabilities available in the market today. AuthenTec is protected by 35 issued U.S. patents and 31 U.S. patent applications.
- Low-Cost Advantage: AuthenTec’s sensors use less silicon as compared to other commercially available silicon-based solutions, which provides a significant cost advantage over competitors. In addition AuthenTec utilizes a fabless manufacturing model, which allows them to focus on differentiating their products and making them better, not on manufacturing and infrastructure.
- Comprehensive Fingerprint Authentication Solutions: AuthenTec’s comprehensive solutions include the sensors, algorithms, software and reference designs that allow customers to easily integrate their solutions into products. AuthenTec is working on better software capabilities, such as software drivers and algorithms that they produce for their customers, that they believe will improve their value proposition significantly and will increase revenues in 2009.
- Multiple Products Targeted for High Volume End Markets: As a result of being a focused semiconductor company, AuthenTec has introduced 16 products tailored specifically to their target markets and as a result, their products include some of the smallest fingerprint sensors available in the market, a critical consideration for many of their customers.
- Strong Relationships With Leading Global PC and Wireless Device Manufacturers: Take a look at AuthenTec’s customer base and you can see that they are entrenched among some of the highest volume and best known PC and Wireless vendors in the World. These strong relationships enable AuthenTec to work with their customers and tailor solutions to fit into their research and development efforts and make their efforts run smoother.
- Increased Functionality With the Power of Touch: AuthenTec’s products also provide other features such as TrueNav and TrueYou. TrueNav allows the sensor to be used as a “touchpad” or “joystick” type device where the sensor tracks the motion of the finger. TrueYou allows the sensor to be used to personalize or customize customers’ products, such as using a different finger to launch a corresponding application in a computer or cell phone.
Business Outlook
AuthenTec makes money by selling their products to original equipment manufacturers, or OEMs, original design manufacturers, or ODMs, and contract manufacturers.
These manufacturers in turn, implement AuthenTec’s sensors into their products in a wide range of devices and sell them to other manufacturers, or directly to the public as finished products.
The products that were described above, such as cell phones, PC’s and peripherals, take a significant amount of time to produce and implement with AuthenTec’s technology.
AuthenTec’s sales cycle begins with their marketing, sales staff and application engineers engaging with customers’ system designers and management, which is typically a multi-month, or even multi-year process. In fact, some of AuthenTec’s customers may need as much as 3 years from initial contact to actually making a purchase of AuthenTec’s sensors.
If they are successful, a customer will decide to incorporate AuthenTec’s solution in its product, but because the sales cycles for their products are long, AuthenTec incurs expenses to develop and sell their products, regardless of whether they achieve a design-win and well in advance of generating revenue, if any, from those expenditures.
AuthenTec does not have long-term purchase commitments from any of their customers, as sales of their products are generally made under individual purchase orders.
However, once one of their products is incorporated into a customer’s design, it is likely to remain in that product for a long time because of that same lead-time.
Consider this process like when a car manufacturer designs a new model car. It takes years of planning, development, testing, etc., before that car ever hits the market. But once it does, you can bet that that model will be around for years to come with only slight changes in its design because of all the up-front expenses.
AuthenTec has experienced revenue growth due to an increase in the number of products offered, an expansion of their customer base, an increase in the number of design-wins within any one customer and an increase in the average revenue per design-win.
Also, as stated before, AuthenTec does not own or operate their own production semiconductor fabrication, wafer bumping, assembly or test facilities and by outsourcing manufacturing, they are able to avoid the cost associated with owning and operating their own manufacturing facility and take advantage of the scale of operations these third parties provide.
AuthenTec operates in a rapidly growing marketplace that is predominately located overseas, and specifically in Asia.
In looking at the AuthenTec story, one must first start with their growing, but highly concentrated customer and regional base.
Outlined below is a table that will help you understand this distribution, and the trends associated with AuthenTec’s sales over the last few years.
Sales To Overseas/Major Customers:
As you can see, AuthenTec’s sales are primarily concentrated overseas, specifically in Japan and Asia. The U.S, Canada, and Europe account for a very small amount of total sales.
Of course, early adopters of new technology are always found in Asian markets.
Think about cameras in cell phones about 5 years or so ago. It was unheard of to have a cell phone with a camera in the U.S. at that time, now every cell phone has a camera in it!
I believe that same market dynamic is at play, and the growth potential for AuthenTec’s products in other markets is extremely large and growing rapidly.
Also, as illustrated in the table, AuthenTec has a very concentrated customer base. This is not something you like to see, but is inevitable with a small rapidly growing company like AuthenTec that produces a niche product.
The good news is that AuthenTec has been diversifying their revenue stream over the last several years to more and more customers, and as they grow, this trend will continue, which will give them more of a buffer if they lose a large customer.
Outside of Japan, wireless network carriers are still evaluating the value proposition of integrating fingerprint sensors into devices sold for use on their networks.
This can be looked at in 2 ways: AuthenTec has a huge market opportunity as more and more cell phone operators integrate fingerprint sensors into their phones, or this is a small market because other countries that aren’t like tech-centric Japan, shy away from radical design changes to already popular wireless devices.
I tend to think that over time, all wireless carriers would love to incorporate features that would make their phones more attractive and differentiated from the rest of the crowd. Again, think of the first cell phones with cameras in them.
Just think of the possibilities for fingerprint sensors:
- GPS devices: of which AuthenTec’s sensor was just installed in the first commercially available model in Europe.
- Automotive applications: Things like entry systems on doors or key fobs, ignition systems, etc.
- Other access control devices: Any door, gate, lighting system, etc., can install AuthenTec’s sensors.
- Personal Devices: Sensitive data like hard drives, flash memory cards, etc., can all contain AuthenTec’s sensors, and in fact some already do.
- Payment Gateways: Already in Japan there is a fast growing market for payment called M-Commerce, or Mobile Commerce. See “Market Trends” below for more information on this.
- Any other of a myriad of applications. Things that I can’t even think about yet that are practical and feasible. Use your imagination and the possibilities are endless.
As a result of AuthenTec’s current products as well as yet-unknown products, I believe we are on the cusp of a growing, and just-turned-profitable business that can be a core holding for years to come based on not just what they are currently doing, but more for what they can and will do.
The market for biometric sensors is growing rapidly and according to AuthenTec, the addressable market for their fingerprint sensors is over 1 BILLION units per year within the segments described below.
As more and more people put sensitive data onto laptops, cell phones, PDA’s and other personal devises, the need for a better and more efficient means to protect that data is growing and in high demand. Forget about simple stuff like passwords, consumers are looking for a more robust and high-tech way to protect their data, their homes and to make life easier.
This doesn’t even include markets that already rely heavily on authentication devices such as banks, government buildings and facilities, the military and private sector businesses looking to protect their data and the integrity of their businesses.
In 2006, businesses and consumers lost approximately $49.3 billion to identity theft, according to Javelin Strategy and Research.
On average, corporate data breaches are costing companies $6.3 million per incident, according to a 2007 benchmark survey by the Ponemon Institute. Ponemon’s third annual survey on the impact of data breaches shows that despite more awareness of the high price that breaches bring, the average cost of such rose 8% to $197 per record compromised, a 43% jump from 2005.
As the need for password systems in businesses increases, the management of such systems becomes continuously more expensive in terms of real costs and lost productivity.
Above and beyond this data, AuthenTec is poised to take advantage of a growing trend in Japan and elsewhere called M-commerce, or mobile commerce, where customers can pay for transactions using their cell phones. AuthenTec estimated that over 10% of M-Commerce enabled cell phones shipped in Japan in 2007 included a fingerprint sensor.
Specifically, AuthenTec is targeting the following markets:
- PC’s: The PC market, particularly laptops, currently represents the largest market segment using fingerprint sensors. According to IDC, a leading market research and analysis firm, approximately 105.3 million laptops were shipped in 2007, up from 82 million laptops in 2006. Of this amount, AuthenTec believes approximately 20% of laptops shipped in 2007 had an integrated sensor, up from 10% in 2006.
Laptop shipments are expected to grow at a compounded annual growth rate, or CAGR, of approximately 12% from 2007 to 2009, down from previous expected growth of 17.2% from 2006 to 2010, reflecting the potential slow-down in the world economy.
In addition, the desktop and PC peripheral markets also represent significant market opportunities for AuthenTec’s products.
AuthenTec estimates these two markets represent over 500 million units shipped in 2007.
- Wireless Devices: AuthenTec believes the integration of fingerprint sensors into wireless devices is in its early stages and will accelerate consistent with the adoption rates of other wireless device features that first found acceptance in the Japanese market such as camera functionality, internet access and mobile television.
According to IDC, over 1.0 billion wireless devices were shipped worldwide in 2006 and over 1.2 billion were expected to ship in 2007, and this market is expected to grow at a CAGR of approximately 7% from 2006 to 2010.
AuthenTec believes the demand for their products will grow as M-commerce expands globally with the use of wireless devices as a means of commerce. M-commerce is a well-established means of executing financial transactions in certain countries such as Japan.
Consumers embrace M-commerce because of its convenience and security advantages while service providers and credit card companies value the revenue opportunities it creates.
According to ABI Research, over 20% of the phones shipped worldwide by 2012 are expected to be M-commerce enabled.
Trials for M-commerce phones and applications are starting to ramp up, especially in other countries, like the US.
In fact, point of sale (POS) terminals are already in place to take M-commerce for phones, since they already use a card or “fob” for transactions at present.
With the competition in the cell phone market, manufacturers are always looking to differentiate their services and products from other companies and therefore, might be looking more and more into M-commerce capabilities in the US over time.
In Japan, the AuthenTec phones came BEFORE the M-commerce capabilities, and were marketed as such for protecting privacy, etc.
AuthenTec believes that M-commerce will become a “killer app” and that they have a great chance of becoming ubiquitous in this niche.
Visa and Mastercard typically limit transactions to about $80 for the card sensors and “fobs” that are currently in use, so for the cell phone market, they wanted to eliminate that limit, therefore, they required some type of authentication system, and that’s where AuthenTec’s sensors come into play.
- Access Control: While physical access control presently represents the smallest of AuthenTec’s three markets, the adoption of fingerprint sensors in this market is being driven by the desire to replace or complement traditional access methods including keys and keycards.
According to Frost & Sullivan, a leading business research and consulting firm, the North American electronic access control market generated estimated revenue of approximately $1.3 billion in 2006 and is expected to reach $4.2 billion in 2010.
Fingerprint Biometrics Market
The International Biometrics Group, or IBG, estimates that worldwide biometric revenue will grow from approximately $3.0 billion in 2007 to approximately $7.4 billion in 2012, representing a CAGR of approximately 20%.
The largest share of this revenue is generally derived from criminal justice and civil oriented applications and includes such applications as the federal, local and state criminal justice systems, driver licenses, the US-Visit program and similar programs throughout the world.
According to IBG, fingerprint biometrics, is one of the fastest growing sub-segments of the overall biometrics market.
A 2007 report from Research and Markets on biometric market trends says that fingerprint recognition is expected to remain the dominant technology in terms of revenues and number of deployments in the financial sector.
Its advantages of acceptable accuracy, low hardware costs, and wide applicability to different financial applications will drive its dominance.
According to AuthenTec’s 10-K:
“The silicon fingerprint sensor market is a sub-segment of the global fingerprint biometrics market and includes sensors based on various technologies of varying capabilities, size and cost. Although still in its early stages, the market is growing rapidly. According to the most recent report from Frost and Sullivan, the overall silicon fingerprint sensor market is expected to grow from 2006 at a CAGR of over 50% to $2.0 billion by 2013. They forecasted that approximately 21.8 million units would be shipped in 2007 worldwide. Growth in the fingerprint sensor market is being driven by a variety of factors including:
- heightened awareness of the need for security
- demand for enhanced security as PCs and wireless devices continue to store additional sensitive data
- proliferation of portable electronics
- inadequacies and/or expense associated with various security solutions
- growth in E- and M-commerce
- need for small and cost-effective solutions catering to high volume end markets
- desire for additional functionality such as navigation and personalization features.
The silicon fingerprint sensor market, the market in which we operate, comprises two different types of products: touch and swipe sensors. Touch, or area, sensors are generally larger and more costly than swipe sensors. Users of touch sensors place their finger on the sensor. Swipe sensors are generally smaller and less costly and involve the user swiping their finger across the sensor. Swipe sensors have become the more dominant form factor over the past few years and now represent a significant majority of sensors shipped.”
As you can see, the potential market for AuthenTec is very large.
I did some number crunching and came up with the following for their growth potential:
25.3% of the overall biometric sensor market is fingerprint sensors. This year that’s expected to reach about $3 billion dollars, so that equates to about $759 million in gross sales for the fingerprint market.
By 2013, this market will grow to about $2.0 billion.
Right now AuthenTec has about 6.8% of the market share if you go by total sales figures alone.
If we take that out for the next 5 years, AuthenTec will get about $125 million in sales from this segment alone, assuming no gain in market share, representing a 20% CAGR. Not bad for a small company.
However, I believe as AuthenTec enters new markets and expands their business and takes more market share, this figure will be at least double, representing a huge upside potential for AuthenTec.
This is the next great market in terms of adoption for value-added convenience to personal electronic devices such as cell phones, laptops and other devices where a quick swipe of a finger would add an extra layer of protection to your device and data, without increasing the overall cost by much.
In addition, these devices are becoming cheaper and more mainstream and it won’t be long before we see AuthenTec’s fingerprint technology in every walk of life, from not only PC’s and cell phones, but also in things that perhaps are in the works or we might look to in the future such as unlocking car doors (or even starting the engine), various remote control devices like TV remotes, garage door openers and the like, and a multitude of other applications that I haven’t even thought of or are underway as we speak.
In fact, AuthenTec is the recognized volume supplier leader of biometric fingerprint sensors worldwide — shipping nearly two thirds of all sensors sold in the PC, wireless and access control markets during the past five years.
The company continues to win new designs with the world’s Top 10 PC manufacturers as its fingerprint sensors will be integrated into more than 300 PC models by the end of 2008.
Competitors
The fingerprint sensor market is highly competitive and will remain so going forward.
Although AuthenTec has a patented technology, in the world of electronics, that still doesn’t mean much when you are competing on price, as AuthenTec does in many markets.
There are several companies that compete directly and indirectly with AuthenTec. Some companies compete with AuthenTec only within certain divisions within that company.
AuthenTec’s largest U.S. publicly traded competitor in this category, and a company that is suing AuthenTec, is Atmel Corp (Nasdaq: ATML). (See Risks below.)
A couple of other competitors that are publicly traded in other countries that operate fingerprint sensor technology units include Lite-on Technology Group and Mitsumi Electronic Co. Ltd.
Some private competitors include: Atrua Technologies, Inc., Fidelicia Microsystems, Inc., Symwave, Inc., UPEK, Inc. and Validity Sensors, Inc.
Out of these companies, UPEK is the largest competitor to AuthenTec in the private sector, with competing technology on many fronts, and is regarded as the #2 manufacturer of fingerprint sensors with many of their designs being utilized by many of the top manufacturers in the PC And Wireless market.
Bottom Line: Competition abounds on all sides. AuthenTec is the leader in their field with a proven, cost-effective and patented technology, and they are firmly entrenched as the incumbents, but as we’ve seen in other business segments, like search engines, being the biggest and best now means nothing when an upstart comes knocking at your door and erodes your market dominance.
Management
Here’s a brief rundown of AuthenTec’s management from their prospectus:
Executive Officers and Directors
“The following table shows information about our executive officers and directors as of March 30, 2007:
Executive Officers
F. Scott Moody is our co-founder and has served as a director and our Chief Executive Officer since inception. He was elected as Chairman of our board of directors in October 2006. From inception to July 2006, he also served as our President. Prior to founding the company in 1998, Mr. Moody was the Vice President of the Core Products Division of the Semiconductor Sector of Harris Corporation, or Harris, now Intersil Corporation. Mr. Moody began his career at Harris in 1980, during which time he held positions in engineering, program management and marketing. Mr. Moody received a BS degree in Industrial Engineering from North Carolina State University and an Executive MBA from the University of Florida.
Lawrence J. Ciaccia, Jr. has been our President since July 2006. He joined us as Executive Vice President of Marketing in March 2005. From March to November 2004, he was Vice President and General Manager of the wireless data and networking component products division at Conexant Systems, Inc. From 1999, he held the same position through a series of acquisitions with Globespan Virata Inc. and Intersil. Mr. Ciaccia began his career as a design engineer in 1980 with the Semiconductor Sector of Harris. Mr. Ciaccia received a BS degree in Electrical Engineering from Clarkson University and an MBA from Florida Institute of Technology.
Gary R. Larsen has been our Chief Financial Officer since December 2006. From April 2005 to December 2006, Mr. Larsen served as Chief Financial Officer of Artesyn Technologies, Inc. Mr. Larsen also served as Artesyn’s Corporate Controller from May 1999 to April 2005. Prior to joining Artesyn, Mr. Larsen served in a variety of management positions with W.R. Grace & Co. Mr. Larsen began his career with KPMG Peat Marwick, LLP. Mr. Larsen received a BS degree from the State University of New York at Buffalo and an MBA from Leonard N. Stern School of Business at New York University. Mr. Larsen is a certified public accountant.
Anthony Iantosca has been our Vice President of Quality Operations since August 2000. Prior to joining us, Mr. Iantosca was a director with Signetics Corporation from 1999 to August 2000. Prior to that, he was the Director of Operations for Catalyst Semiconductor Inc. from 1995 to 1999. Prior to joining Catalyst, Mr. Iantosca served as Director of Offshore Manufacturing for Cypress Semiconductor Corporation. Mr. Iantosca received an MBA from the J.L. Kellogg Graduate School of Management at Northwestern University, an International MBA from the Hong Kong University of Science and Technology, and an Electronic Engineering diploma from the GTE Sylvania Technical School.
Frederick R. Jorgenson has been our Vice President and General Counsel since November 2006. Prior to joining us, Mr. Jorgenson was Senior Counsel for intellectual property and licensing at Raytheon Company from October 2005 to November 2006. From April 2005 to October 2006, Mr. Jorgenson served as a consultant, after having served as the Chief Executive Officer of RJ Mears, LLC from January 2003 to April 2005. From October 2000 through January 2003, Mr. Jorgenson served as an Assistant General Counsel of Fujitsu Network Communications, Inc. Prior to that, Mr. Jorgenson served as intellectual property and licensing counsel with Harris. Mr. Jorgenson received a BS degree in Electrical Engineering from Florida International University and a JD degree from Florida State University.
Dale R. Setlak co-founded the company and has been our Vice President and Chief Technical Officer since October 1998. From 1990 to 1998, Mr. Setlak served as Senior Principal Engineer with Harris’ Electronic Systems Sector. Prior to joining Harris in 1990, Mr. Setlak served as a Senior Systems Architect at CTG-Scientific Systems Services and was the Senior Instrumentation Engineer at Babcock and Wilcox. Mr. Setlak received a BS in Electrical Engineering from Ohio State University and a MS in Computer Engineering from Florida Institute of Technology.
Peter E. Sherlock has been our Vice President of Product Development since February 1999. Prior to joining us, Mr. Sherlock was the Director of the Raleigh (NC) Design Center for Integrated Device Technology, or IDT. Prior to joining IDT, Mr. Sherlock served as Vice President of Business Development and Operations at IVEX. Mr. Sherlock received a BS degree in Electrical Engineering from the University of Salford, UK.
Arthur L. Stewart has been our Vice President of Worldwide Sales since February 2007, and served as our Vice President of Business Development from August 2005 to February 2007. Mr. Stewart joined us in 2001 as the Wireless Segment Director. Prior to that, Mr. Stewart co-founded a start up corporation focusing on position tracking through cellular technologies. Mr. Stewart also held various engineering and business development positions at Harris. Mr. Stewart received a BS degree in Electrical Engineering from the University of Delaware and an MBA from Florida Institute of Technology.
Board of Directors
R. Kent Buchanan has served as a member of our board of directors since March 2006. Since March 2005, Mr. Buchanan has been Vice President, Corporate Technology and Development and Chief Growth Officer for Harris. Prior to joining Harris, Mr. Buchanan was the Senior Director of growth platforms at Motorola, Inc. During 15 years with Motorola, he held a number of leadership positions including Vice President and General Manager Global eBusiness, Vice President and General Manager Radio Products Division, Vice President and General Manager Accessories and Aftermarket Products Division, as well as assignments in international network services and strategic marketing.
Matthew P. Crugnale has served as a member of our board of directors since our founding in 1998. Mr. Crugnale has been the President of Crugnale Associates, a Silicon Valley based high technology consulting firm since 1982. Prior to that, Mr. Crugnale co-founded Gnostic Concepts, which was later acquired by McGraw-Hill. Mr. Crugnale was also the Vice President of Marketing at Beckman Instruments and has held various management positions at General Electric. Mr. Crugnale also serves on the board of advisors for Sunbridge Partners, a venture capital firm.
Robert E. Grady has served as a member of our board of directors since June 2004. Since May 2000, Mr. Grady has been a Managing Director with the Carlyle Group where he serves as Managing Partner of the Carlyle’s U.S. venture funds and global head of venture and growth capital. Prior to joining Carlyle, Mr. Grady was Managing Director and member of the Management Committee at Robertson Stephens & Company. Previously, he served in the White House as Deputy Assistant to President George H.W. Bush and Executive Associate Director of the Office of Management and Budget.
Gustav H. Koven III has served as a member of our board of directors since 1999. Since 1999, Mr. Koven has been a manager of Knickerbocker 1999 Direct Investments LLC. Mr. Koven has been the Managing Member of Wildfields Venture Advisors LLC since 2003 and has been a manager of HT 1999 Direct Investments LLC since December 2004. Mr. Koven’s role as a manager of Knickerbocker 1999 Direct Investments LLC and HT 1999 Direct Investments LLC is with respect to investments of those entities in portfolio companies other than the investment in our company, for which he no longer has any management role. Mr. Koven was the Managing Director of Knickerbocker LLC from 1999 to 2003. From 1990 to the present, Mr. Koven has been a partner in a number of Edison Venture Fund partnerships. Prior to joining Edison, Mr. Koven was the President of Chase Manhattan Capital Corporation and Chase Manhattan Investment Holdings.
Yunbei “Ben” Yu has served as a member of our board of directors since February 2003. Dr. Yu joined Sierra Ventures in April 2000 where he serves as a Managing Director. Dr. Yu also serves as a special committee member to Gobi Partners in Shanghai, China. Prior to joining Sierra Ventures from December 1997 to March 2000, he worked at 3Com Corporation, where he held a number of engineering and project management positions.
Our board of directors currently consists of six people. Effective upon the closing of this offering, our amended and restated certificate of incorporation will provide that the authorized number of directors may be changed only by resolution of the board of directors. The majority of the members of our board of directors are independent as defined under the Nasdaq Stock Market rules.”
Insider/Institutional Ownership
Insider Ownership:
It’s always a good idea to make sure that the owner’s interests are aligned with yours. So let’s take a look at the insider ownership for AuthenTec.
According to the company’s latest 10-K, Executive Officers and Directors, current 5% or greater stockholders and affiliated entities owned about 49.8% of the company.
Executive Officers and Directors owned about 8.8% of the company’s shares after the close of their IPO according to their prospectus.
We’ll have to wait till the latest Proxy statement is filed before I can update these numbers further.
According to the prospectus (the last time AuthenTec published ownership of share data), CEO and Founder Scott Moody owns about 5% of the shares outstanding after the close of the IPO.
Although lower than I would like, I understand that insider ownership in this type of company with larger capital expenditures and start-up costs as well as time-to-market and profitability requirements, will be inherently lower than other types of businesses that are still headed by the founder.
Still, I like the fact that the founder still has some skin in the game, and owns 5% of the shares outstanding and bought more on the open market.
Insider Purchases/Sales:
Also, a few months after AuthenTec went public, the CEO was buying shares on the open market at around $10-11 per share. His total purchase was 10,000 shares. A small but sizeable stake.
Since that time, the CEO has sold over 168,000 shares, with most of that coming in the last month (March, 2008), as the stock has reached all-time lows. This is not something I like to see.
On a positive, albeit very small note, Gustav Koven, a director, just recently purchased 2,000 shares on the open market (March 13th, 2008). I want to see more insider buying and at the very least, no more insider selling.
Institutional Ownership:
131 institutions own 32.8% of the 28.02 million common shares outstanding. This is lower than the average institutional ownership for the Semiconductors Industry at 66.8%, and lower than the average of the S&P 500 as a whole, which is 72.1%.
Here’s the most recent Quarter change in Ownership:
Shares Purchased (Most Recent Quarter) 4.59 mil
Shares Sold (Most Recent Quarter) 1.74 mil
Net Purchases (Most Recent Quarter) 2.85 mil
Net Change (Most Recent Quarter) 42.9%
Most of the 5%+ stockholders that own AuthenTec’s shares are original investors in the company that helped to fund its operations and start-up costs. Companies like Harris Corp, and Sierra Ventures, all own sizeable stakes, and have begun to sell shares on the open market.
I believe these stake holders represent a more solid and stable share base than traditional funds because they are original investors in the company, and not looking to profit from AuthenTec’s share price the first chance they get, however that being said, the recent selling activity, specifically by Harris corp. is more than a little disturbing to me.
This is always something to keep an eye on as heavy institutional ownership can move the stock one way or another rather quickly.
Institutional Purchases/Sales:
Within the last couple of months (Jan-March 2008), original backers in AuthenTec have sold about 1.9 million shares on the open market, with Harris Corp. being the largest seller. It looks like they are trying to divest their interest in AuthenTec since Harris Corp. is a publicly traded company, and can garner some extra earnings each quarter from their AuthenTec stake.
Again, this is something to watch very closely.
III. Financial Performance
Selected Financial Data
AuthenTec is a rapidly growing business that has never been profitable for an entire fiscal year, although they just had their first profitable quarter in Q3 and continued that in Q4, 2007, and are expected to be profitable for the entire 2008 fiscal year.
Let’s take a look at the growth trends and overall financial performance within AuthenTec‘s business over the last 3 years, with 2008 estimates where applicable.
Sales growth has been robust, with a strong acceleration from 2005 – 2006. In 2007, AuthenTec’s growth outpaced Wall Street’s estimates each quarter, ending up at a robust 58% in 2007. 2008’s growth is expected to moderate to about 43%, but again, this growth has already been revised upwards several times by analysts, and I expect they’ll continue to do the same as AuthenTec continues their business momentum. While not shown here, analysts expect growth of about 40% for 2009, so although things are slowing down slightly, this is still very heady growth for a small company like AuthenTec.
As for cash flow, AuthenTec has improved this line item each year, and is expected to do so again in 2008. The same goes for free cash flow, which took a bit of a hit in 2007 because of some one-time capital expenditures needed to grow and expand the business. Most years, because AuthenTec is a fabless company, their capex is very low, and therefore, as they approach break-even on the cash flow side, so to will their free cash flow.
Either way you slice it, AuthenTec is kicking some butt in terms of top line growth, and finally, bottom line growth in terms of profits as evidenced by their expected $.19 EPS profit this year, expected to more than double to $.43 next year.
Also, note that diluted shares increased exponentially because of their IPO.
Here are the highlights from their latest earnings announcement on February 4th, 2008.
As we can see, AuthenTec’s year-over-year comparison shows tremendous growth from the 4th quarter of 2006 to the 4th quarter of 2007.
AuthenTec also had their first operating profit ever as a public company, showing a slight gain from continued losses in the past, and this was the first quarter that they were profitable on both a GAAP and non-GAAP basis.
Since they weren’t public for the comparison quarters, obviously there is a large discrepancy in the earnings per share. From here on out though, the comparisons will be using roughly the same number of diluted shares.
Cash equivalents and investments totaled $66.3 million as of December 28th, 2007. The company has NO debt, and used about $720,000 in cash in the latest quarter.
Furthermore, AuthenTec raised their guidance for the 1st quarter of 2008 (which I think they will handily beat), on both the top and bottom line numbers.
Margin Trends
Looking at a company’s margins is critical to understanding their past performance and future prospects. Usually, businesses start out with smaller margins and they expand over time as the business becomes more efficient, and scales.
As you can easily tell from this table, AuthenTec has been scaling their business, and getting closer and closer to turning a profit.
In their latest quarter they finally were able to turn an operating profit, and it’s just going to get better and better from here.
Now let’s take a look at AuthenTec’s last 6 quarter margin trends.
Last 6-Quarter Margin Trends:
Now this is what I like to see. Look at the steady ramp up of all three margins: Gross, Operating, and Net. Also note that their last quarter led to the first positive operating margin in their history.
These trends show a strengthening business that is poised for further growth and margin improvement. Any addition to their top line, will start dropping a bigger and bigger chunk to their profit.
Valuation Metrics
(Note: Valuation metrics calculated using $10.50 share price. Please adjust accordingly.)
Because we are at a disadvantage (or extreme advantage depending on how you want to look at it!) when trying to pin down a valuation for AuthenTec, using traditional valuation techniques is difficult and an exercise in art more than science.
Let’s start with the Discounted Cash Flow Analysis (DCF):
DCF is often called the king of all valuation metrics because it measures a company’s actual ability to generate cash from operations, and in the end, that’s all that really matters.
Other metrics like P/E ratios and P/S ratios, can be manipulated by the company or not lead to a truthful analysis of the business because of accounting shenanigans, but DCF can’t be made up. You are either making and retaining cash, or you aren’t, simple as that.
When assessing a company’s “fair” or intrinsic value using a DCF analysis, many assumptions must be made.
Everything from the potential growth prospects of the company’s earnings, to their tax rate, overall market’s return, risk free rate of return for bonds, their debt ratio, etc.
In other words, using this type of analysis is far from an exact science because you need to make assumptions for the next 5-10 years that may or may not EVER come true.
For instance, a Price-to-Sales (P/S) ratio can be measured in absolute terms: The company’s market cap on that day, divided by their total sales. Easy, simple, clean and exact.
However, with a DCF analysis, there are many variables that need to be accounted for that can change in an instant.
Why do we use this analysis tool then? Because it is one of the most definitive measures of a company’s worth if we look into the future and determine what it can earn for the next 5-10 years and ultimately, beyond.
This analysis gives us a “terminal” value of the shares, and what they are worth right now, based on all our assumptions.
This is also commonly referred to as the intrinsic value of the stock, or it’s absolute highest value based on all our assumptions.
When using this modeling, I typically account for 3 scenarios:
When using this modeling, I typically account for 3 scenarios:
- The best-case scenario: This scenario typically assumes the highest growth rates, margins and cash flow, and also assumes the lowest volatility, tax rate, debt levels, etc. for the company you are analyzing.
- A middle scenario which is the most likely, with moderate assumptions on growth rates, margins, cash-flow, volatility, tax rates, debt levels, etc.
- The worst-case scenario: This scenario typically assumes the lowest growth rates and margins, and also assumes the highest volatility, tax rate, etc. for the company you are analyzing.I won’t go into detail on how this is done, but suffice it to say there are calculators on the web that can do DCF, as well as proprietary spreadsheets and systems that all financial firms use.
I won’t go into detail on how this is done, but suffice it to say there are calculators on the web that can do DCF, as well as proprietary spreadsheets and systems that all financial firms use.
Using a modified DCF analysis, here’s what I get under these 3 different scenarios:
- Best Case Scenario: AuthenTec’s shares are valued at anywhere from $12.88 - $17.91 per share ($15.36 median)
- Middle Scenario: AuthenTec’s shares are valued at anywhere from $8.09 - $9.97 per share. ($9.03 median)
- Worst-Case Scenario: AuthenTec’s shares are valued at anywhere from $4.27 - $4.52 per share ($4.40 median)
So using this measure of valuing a company, I get an average share price range from: $4.40 - $15.36, taking the midline of each scenario.
With AuthenTec’s shares trading at about $10.50 as of this writing, AuthenTec looks fairly or slightly overvalued according to this metric.
More to the point, I believe the midline model is most accurate because it is conservative, while being realistic with growth rates and assumptions made about acquisitions and organic growth.Using this metric, AuthenTec’s share value is trading in-line with its intrinsic value of about $9.00 per share.
Now, of course, DCF can’t be used on it’s own, especially in light of the fact that AuthenTec has no track record for profitability, and needs to be used along with other measures of value, so to that end, I have detailed some more valuation metrics below that are more traditional.
Bottom Line: AuthenTec is already trading at a “fair” value according to the DCF model that I am using. Because AuthenTec has so many shares outstanding, and is in a highly cyclical and volatile market, I would feel much more comfortable with these numbers favoring us more significantly than they do now.
Traditional Metrics:
To make things easier, I have created a table that includes all of AuthenTec’s valuation metrics vs. a few comparable companies that are public, as well as their overall industry, which is the Semiconductor - Specialized industry.
Since AuthenTec has no public company that it competes with directly (there are a few companies that make fingerprint sensors as a subset of broader product offerings), I made certain assumptions and chose certain companies that I thought matched up well with what AuthenTec does, and where I think they should be valued in terms of their growth prospects, margins, etc.
AuthenTec competes more as a faster growing specialized semiconductor company than a traditional semi company.
So, to that end, I included the following companies:
- Atmel Corp. (Nasdaq: ATML): Is the only US publicly traded company that competes directly with AuthenTec. Atmel engages in the design, development, manufacture, and sale of a range of integrated circuits (IC) products, which include fingerprint sensors. Atmel has also brought a lawsuit against AuthenTec for patent infringement as stated above.
- Zoran Corp. (Nasdaq: ZRAN): Zoran Corporation engages in the development and marketing of integrated circuits (IC) and related products used in digital versatile disc (DVD) players, movie and home theater systems, digital cameras, professional and consumer video editing systems, and digital speakers and audio systems.
- Cavium Networks, Inc. (Nasdaq: CAVM): Cavium Networks, designs, develops, and markets semiconductor processors for intelligent and secure networks. Its products allow customers to develop application-aware and content-aware networking equipment that securely processes voice, video, and data traffic at high speeds. The company’s products also include a suite of embedded security protocols that enable unified threat management (UTM), secure connectivity, and network perimeter protection.
Remember that all valuation metrics for AuthenTec are calculated using a $10.50 per share value.
Price to Sales Ratio (P/S):
If we use this common metric for companies that have yet to turn profitable for any meaningful timeframe, we can see that AuthenTec is significantly undervalued when compared to its peers.
Its closest rival that also makes fingerprint sensors, Atmel, is trading at a P/S of .93, but actually had SHRINKING sales last year!
If we look at the other comparable companies to AuthenTec, the only one that grew revenues at about the same rate as AuthenTec, is Cavium Networks.
As you can see, Cavium garners a premium for their growth and profitability way above the industry norm, or compared to its peers as well.
The industry grew last year at an anemic 8.4% and the average P/S ratio of the companies within it was 4.3. AuthenTec is projected to grow sales 5 times faster than the industry average. That would warrant at least a P/S ratio of at least double the industry average, similar to what Cavium is receiving, at about 3 times the industry average.
Bottom Line: Fast growing companies always deserve a higher multiple than slower growing companies. I believe that AuthenTec’s shares are trading at a discount to this growth using the P/S metric by about 100%.
AuthenTec just started earning a profit, so using a backwards P/E, and even a forward P/E ratio, isn’t as useful as other metrics at this point in AuthenTec’s growth cycle.
AuthenTec’s profit is going to explode in the coming years, but for now, they are negative in terms of their trailing earnings, and forward earnings are going to be low for a while as a result, but ramp up very quickly.
Analysts are pegging their earnings to be about $.19 per share in 2008 and $.43 per share in 2009, which I feel are both conservative numbers.
Remember, you pay for the future of a company, not the past, so let’s look at those numbers:
The industry average is 21.50, while their closest rival Atmel’s P/E ratio on a trailing basis was negative, and is expected to be about 19.0 for this year.
Using this metric, AuthenTec looks overvalued and rich, but again, a fast growing company (the average growth in their industry was about 8% during 2007) deserves to be valued higher, and remember that AuthenTec just became profitable, so a basic P/E ratio is almost useless until a few years down the line.
In addition, these numbers can change because AuthenTec has BEATEN analysts estimates their first 3 quarters as a public company, by $.01 to $.03 each time.
If they beat estimates by $.02 per quarter (taking a more conservative estimate) over the next 8 quarters on average, then the forward P/E ratios become much more reasonable even while they are still growing those earnings at a fantastic rate.
This makes their shares look much more reasonable, but that far out there is way more risk of them missing earnings (which will hammer the stock price) or some other business event happening (not to mention a slow-down in the business itself), that would bring these estimates into question.
Bottom Line: Using traditional P/E ratio metrics, while useful for more mature businesses, are not as beneficial to us in measuring AuthenTec’s true scale and eventual profitability at this time.
Price to Earnings Divided by Growth (PEG):
The last number that I would like to use is what’s called the PEG multiple.
This takes into account the Price to Earnings (P/E), divided by the growth in percentage terms. So if a company has a forward P/E of 60, and they are growing their earnings by 60% per year, then their PEG ratio is 1.
A good measuring stick to use for risk/reward ramifications, is to look for a forward PEG with some downside protection, so anything around 1 or less is usually considered less risky (although there already is plenty of risk involved when looking that far out ahead, which is why you want a lower PEG multiple and not a higher one).
In 2008 analysts expect AuthenTec’s earnings to grow to $.19 per share over a loss this year (2007) of $(-.01).
Assuming AuthenTec grows earnings from -$.01 this year to $.19 next year, this would yield a growth rate of over 2000%.
However, here’s the catch: when using the PEG ratio, the calculation is usually taken out for 3-5 years. In other words, sure AuthenTec’s growth is absolutely stunning when looked at what COULD happen over the next 2 years or so, but what happens after that when year over year comparisons are harder to make?
What if the growth in earnings per share slows to 50% the following year (2010), and then to only 20% in 2011, and so on?
Well, if we look at the analyst’s expectations for this company (and to be honest I think they are conservative), they are giving AuthenTec a forward growth estimate of 35%.
That changes things and gives the PEG ratio of 1.54 (55.26 P/E / 35% Growth).
Hmm…doesn’t look like such a screaming bargain now does it?
But because AuthenTec is growing by leaps and bounds, this metric again doesn’t do justice to the overall picture of their growth and profitability trends.
If we take the analysts 2009 estimates of $.43 per share of earnings, we get a forward P/E ratio of 24.42 using 2009 numbers.
This yields a PEG multiple of .70 which brings us much closer to a fair and undervalued state.
But because these multiples are so forward looking, I don’t think it’s yet appropriate to put too much weight into them for purposes of valuing AuthenTec at this time, but put them more in a moderate bent for valuation purposes.
Bottom Line: Using the PEG multiple valuation metric, while flawed, gives us a better indication of AuthenTec’s potential, and its valuation. I believe that using this metric, AuthenTec is undervalued by at least 50% or more, which could prove conservative if they beat estimates again, and raise future guidance.
Other Valuation Metrics
I could go on and on with different valuation metrics, but I tried to stick to the most tried-and-true ones above, and the ones that offer the most realistic and comparable elements to other companies and the industry itself.
Because we are at a disadvantage (or extreme advantage depending on how you want to look at it!) when trying to pin down a valuation for AuthenTec, using traditional valuation techniques is difficult and an exercise in art more than science.
There are tons of other metrics that I could have used to further bolster my case for AuthenTec: things like Enterprise Value to sales, etc., but I could not yet use any tangible cash-flow or EBITDA valuations that require at least 1 year of profits before they are of any use to us.
To keep things simple, and because of a lack of historical and solid data to work with, every other valuation metric would present such a reach in the dark, that I would be basically wasting our time.
The reasonable way to do this is to take a few mainstream valuation techniques, as I have done above, and then once assured that the shares aren’t in another atmosphere and way overvalued, base your investment thesis on the underlying business and growth prospects, because in the end, everything else will come to fruition if the business itself is being managed in a healthy and prosperous way and fundamentals continue to improve.
V. Potential Risks
- Impending Litigation with Atmel Corp: On March 22, 2006, Atmel Corporation filed a complaint against AuthenTec alleging that their fingerprint sensors infringe an Atmel patent.
The complaint was amended on November 1, 2006 to add certain Atmel affiliates as plaintiffs, as well as an allegation that AuthenTec is infringing a second patent.
The second complaint alleges that AuthenTec’s fingerprint image software infringes Atmel’s patent. Atmel is seeking a preliminary and permanent injunction as well as damages in the case.
AuthenTec has in turn filed a counterclaim challenging the validity of the patents and seeking a judgment of non-infringement. The discovery phase was scheduled to end in December 2007, with patent claim construction hearings likely to be held in the second quarter of 2008.
However, Atmel has filed motions with the court to take additional discovery.
At December 29, 2006, AuthenTec accrued the future estimated costs associated with defending this lawsuit in the amount of approximately $2,781,000.
I don’t have to tell you what would happen if AuthenTec either loses this case, or gets some type of injunction thrown at them as a result of it, or has to settle in an unsatisfactory manner. AuthenTec states that they believe they have done nothing wrong and aren’t infringing on anything, but what else are they going to say? We’ll have to hang tight and see how this plays out.
From what I read and understand, these types of legal proceedings are not uncommon in the semiconductor industry, but nevertheless, this is a potentially large case since AuthenTec’s entire business rests on one product that is now being challenged.
Update: On their latest conference call, the CEO said that this suit was going relatively well, and that in the last few weeks they had some rulings that were in their favor, and continue to believe that they don’t infringe, and that the suit should have never been filed. They are also starting to look into going on the offensive in this litigation process as a result. They are even more optimistic in their outcome, according to the CEO.
- Impending Litigation with Atrua Technologies: AuthenTec Inc. announced on March 12th, 2008, that it has filed a patent infringement lawsuit against Atrua Technologies Inc. in the U.S. District Court for the northern district of California.
In its March 12 suit, AuthenTec says that Atrua’s products infringe multiple AuthenTec patents covering fingerprint sensor technologies.
“We filed this patent infringement suit in order to protect one of our most valuable assets, our intellectual property,” AuthenTec Vice President and General Counsel Frederick Jorgenson said a the statement.
Atrua CEO Anthony Gioeli said in an interview that the lawsuit was frivolous.
“This lawsuit is completely without merit,” Gioeli said, reading from a prepared statement. “We do not infringe on AuthenTec’s or anyone else’s patents. We will vigorously defend ourselves in this matter.”
So, add this to the list of potential distractions for the company, and an area where they will incur expenses for legal fees.
Stay tuned to PeakStocks.com for the latest on this situation.
- Fluctuations in the Semiconductor Industry: Like it or not, AuthenTec operates in the semiconductor industry. Like its brethren, AuthenTec is sometimes at the whims of the market and the perception of this cyclical industry.
Although I don’t believe that AuthenTec is a true “semi” player in the strict sense of the word, when valuations drop, and the market reacts negatively to industry trends or news, watch out, AuthenTec will follow suit, regardless of their fundamentals and business prospects.
- AuthenTec’s Reliance on Only One Product: I’ve said it once and I’ll say it again: AuthenTec only sells one product, fingerprint sensors.
This is a huge risk if this market doesn’t grow as expected, they lose key customers, or more competitors enter the market unexpectedly.
Although AuthenTec is well protected because of their patents and current market penetration and dominance, any company that relies on one product is a very risky proposition until they have demonstrated consistent dominance in that one market or a more consistent track record.
- AuthenTec’s Reliance on a Few Customers for over 80% of their Revenue: As previously discussed, AuthenTec relies on only a few customers for a large portion of their overall revenue.
In 2007, HP and Fujitsu Ltd., directly and through their suppliers, accounted for 48.7% and 22.7% respectively of AuthenTec’s revenue. In addition, their top 5 customers accounted for 84.7% of AuthenTec’s revenue in 2007, and 80.7% in 2006.
Now, while this should get better as AuthenTec grows larger and expands their business, for right now and for the foreseeable future, if AuthenTec loses any of these significant customers, their revenue will be impacted in a negative way on a large scale.
- AuthenTec’s Reliance on Customers Outside of the U.S. for 95.8% of Their Business: As previously discussed, AuthenTec gets the majority of their sales from customers in the Asian and Japanese markets.
This isn’t a big risk factor to me, as those markets are typically first adopters, and it means that there is a huge market opportunity in both the U.S. and Europe for AuthenTec going forward, but it is something that you should be aware of.
- Potential Security Breaches: Because AuthenTec’s sensors are used to protect sensitive data in cell phones, PC’s and access markets like garage door openers and security gates, I don’t have to tell you how important it is that AuthenTec’s sensors actually WORK and not allow an intruder to falsely get access to an area or to data that was protected by an AuthenTec sensor.
If they do, the potential negative publicity or backlash and potential manufacturer distrust in AuthenTec’s products can be a huge problem going forward.
- Potential Lumpiness from Quarter to Quarter: As AuthenTec’s sales grow, there may be more lumpiness in their results from quarter to quarter because of various factors that are out of their control such as: new customer and product wins, timing of orders from customers, variability in margins because of product mix, variability of expenses, seasonality and general economic conditions.
In fact, typically, AuthenTec receives the majority of their revenue in the latter half of each fiscal year, with the split typically being 40% in the first half and 60% in the last half of each year.
Now, while we don’t care a whole lot about fluctuations in a business from quarter to quarter so long as the long-term story remains on track, the market certainly will. As a result, expect potentially large fluctuations in AuthenTec’s share price if they ever “disappoint” the Street in any one-quarter’s earnings release as a result of one-time fluctuations because of some of the factors mentioned above.
- Insider Lock-Up Period Expired: The insider lock-up period for selling shares of stock in AuthenTec expired December 23rd 2007.
There have been several insiders selling shares within the last few months (Jan-March 2008) including the CEO, which is something that will need to be monitored closely, especially in light of the fact that as recently as last summer (June 2007) he was openly buying shares on the open market at prices HIGHER than where he sold them. Why the sudden change of heart?
- Short-Term Investment Illiquidity: AuthenTec invests some of their short-term investments in municipal notes and bonds. With the present credit crunch, and investor’s aversion to any risk, and lower returns, some of AuthenTec’s short-term investments are locked into these investment vehicles and they are currently illiquid in that AuthenTec cannot sell them and invest in more liquid securities.
The amount that AuthenTec had invested in these types of securities was only $13.0 million, but nonetheless, it is a slight concern if they are unable to sell these securities and get access to their cash.
Furthermore, they might have to take an impairment charge in the future related to these notes if they are unable to get their money back as a result of deteriorating credit ratings for these agencies and investment vehicles.
I don’t think that this is a huge risk factor, but something to keep and eye on as it speaks volumes to the current environment we are in when a public company like AuthenTec that has no debt and plenty of cash, is even being affected by the outside credit markets.
- Competition: Believe it or not, there is a lot of competition in this market, even though AuthenTec is the leader right now. There are several public companies, such as Atmel Corp., Lite-on Technology Group and Mitsumi Electronic Co., as well as several private companies, that compete directly with AuthenTec.
Rest assured that as a result of this competition, AuthenTec will need to stay on their toes, continue innovating, and keep their prices cost-competitive or risk losing market share.
- Reliance on 3rd Party Subcontractors: AuthenTec relies on 3rd party subcontractors to manufacture their fingerprint sensors. There may be a time when reliance on these contractors creates problems for AuthenTec’s business, such as: unexpected price increases, delays in manufacturing or capacity and quality control issues.
Other risk factors. Things like options scandals, margin deterioration, losing business, losing customers, increased costs, overall market volatility, etc. Pretty much anything that can go wrong within a business is a risk factor, but the ones listed previously are the main risks to the business, with these being secondary, and possibly primary, risk factors going forward that all businesses need to worry about.
IV. Why I Invested In the Company
- Amazing Technology: We already talked about what makes AuthenTec an amazing company and the technology that they are bringing to market, but it bears repeating that all great investments start, at their core, with a fundamental understanding and belief that that core technology can penetrate on a mass-market scale, and yea, even potentially change the way we do things.
As far as AuthenTec is concerned, that technology deals with improving security, safety and privacy. Who wouldn’t want to improve those areas of their lives with little additional cost and with the added convenience that a simple fingerprint sensor can add?
I believe this trend will accelerate going forward, and we’ll see more and more of AuthenTec’s proprietary, patent-protected fingerprint sensors in more and more devices and eventually, these sensors will receive mainstream adoption and AuthenTec will be the beneficiary.
- Huge Growth In an Expanding and Rapidly Developing Market: As the data above shows, the market for authentication services, and specifically for biometric sensors is growing rapidly. With over 20%+ CAGR for biometric sensors, and specifically, over 50% CAGR for fingerprint sensors, we are at the beginning of this technological advancement.
On top of this, most of AuthenTec’s sales are to overseas and specifically, Asian markets.
I believe as their fingerprint sensors become more accepted in the U.S. and Europe, AuthenTec will greatly expand their potential market and penetration and along with AuthenTec’s products and proven track record, should ensure them increasing market penetration, market share gains and protracted dominance for years to come.
- New Company on the Precipice of Fundamental Breakout: If you paid attention to the valuation metrics, margin trends and other financial data provided above, it doesn’t take long to see that not only is AuthenTec trending higher in every major fundamental and valuation-wise way, but they are also gaining steam in ways that will lead to undervaluation by analysts. That includes increasing profit margins, net income, cash flow, etc.
I believe that analyst’s estimates are incorrect for the next 2 years, and as these expectations get shattered, AuthenTec’s shares will trade much higher than they are today.
So while AuthenTec’s shares look fairly priced right now, we might never get an opportunity to buy into this company as shares will always look “expensive” for years to come as AuthenTec enters their true growth and profit years.
- High Margin Business: Because AuthenTec uses a fabless production model, their costs are contained and their visibility and margins are more stable and higher than other semiconductor companies.
Although margins might fluctuate slightly from quarter to quarter because of various start-up costs associated with a new line of chips, a new manufacturing process, etc., once those lines are up to speed, AuthenTec and their 3rd party manufacturers can begin to really ramp up production, squeeze more and more profit out of each chip, and really begin to expand their margin prospects.
Going fabless was a great move for AuthenTec.
- Multiple revenue streams: This is lower on the list for the mere fact that AuthenTec produces essentially one product: fingerprint sensors.
However, it should be noted, that these sensors could be installed into any number of devices.
Right now their primary market is PC’s and cell phones, but as this technology trickles down to other potential applications, it won’t be long before AuthenTec’s fingerprint sensors are being installed in more and more consumer products, and therefore, AuthenTec’s revenue stream will become more diversified, less cyclical and seasonal, and protect them from any potential customer losses in any one sector or market.
- Co-Founder CEO With Large Stake: Scott Moody is the co-founder and CEO of AuthenTec and has been at the helm since 1998. He owns over 5% of the company, which is a very large stake for this type of business because of the venture capital needed to start operations and bring the company to profitability.
Even though he has begun to sell shares on the open market, his stake remains high.
VI. Bottom Line
Hold your shares.
Although AuthenTec has come down in price from my original recommendation, I believe that there are some things to watch out for in the next few months as the AuthenTec story plays out.
AuthenTec may very well be one of those businesses that never looks or gets “cheap”, so nibbling at these levels is probably warranted for longer term investors, but if you already own a sizeable chunk of AuthenTec, looking out into the product pipeline, and growth prospects, I believe that AuthenTec will comfortably beat analysts estimates and continue to execute.
Are there some risks? Sure, that’s the reason a lot of people won’t touch companies like this, but that’s not the way we play things around here.
My initial assessment of AuthenTec still holds true, especially with today’s prices:
My job and passion is to seek out companies that can not only beat the market, but CRUSH the market’s returns for years to come, and provide a risk/reward scenario that doesn’t put us at a disadvantage when we finally purchase shares.
I believe that not only have I found that company in AuthenTec, but also that AuthenTec’s shares will CRUSH the market going forward on a consistent basis.
My low-ball estimate is that we’ll see returns in AuthenTec in excess of 50% over the next couple of years, with a real possibility of a double in this stock within 1 year.
Optimistic? Outlandish? Maybe. But based on my thorough and detailed analysis of the company, its fundamentals and finally, the risk/reward proposition where AuthenTec sits now, I believe that these risks are the kinds we need to be taking.
Do yourself a favor today and buy at least a small position (one that will let you sleep at night), and see how things play out.
At the very least you’ll have some skin in the game and won’t let the current valuation pass you by and potentially miss out on one of the next great companies that is poised to dominate its market and niche for years to come.
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